Weekend reading: A masterclass on passive portfolio construction

Larry Swedroe is one of the best investing writers on the Web. He also writes books, and this week saw a chapter from his clever new one published on the Net.

The piece makes super reading for anyone interested in building simple passive portfolios that seek to capture the returns from various asset classes.

So that’s most of us around here, then!

The case for diversification

We’ve several times explained how simple asset allocation can improve returns and reduce risk.

Unfortunately, hunkered down here in our urban hideaway, surviving on scraps of the Financial Times that fall through the gratings and tuning to the BBC World Service for business updates on our homemade crystal radio, we don’t have access to the industry-strength databases to prove it.

But Larry Swedroe does, and his step-by-step run through building a portfolio on CBS MoneyWatch is clear and persuasive.

Swedroe notes:

Because most investors have not studied financial economics and don’t read financial economic journals or books on modern portfolio theory, they don’t have an understanding of how many stocks are needed to build a truly diversified portfolio.

The answer is a lot. The solution is funds containing hundreds, and as we know the most effective funds to plump for are cheap index funds.

Simply the best

From there, beginning with a classic 60/40 portfolio – that’s 60% in equities and the rest in bonds – Swedroe builds several different portfolios, and shows how they would have performed from 1975 to 2012.

The funds chosen are all US-based and aimed at US investors, but the principles hold true here, too, and lie behind our own Slow & Steady Passive Portfolio, which naturally employs UK funds.

Importantly, Swedroe doesn’t finesse his asset allocations. There’s no “Next we add 3.32% of small cap stocks, as that’s been found to be the optimal percentage to maximise return” nonsense.

I’d be sceptical whenever you see anyone presenting ‘proof’ that you should put 2.33% in Spanish equities or 1.72% in the utility sector or anything like that.

This sort of fine tuning reveals that they’ve mined a database for specific and unrepeatable outcomes in the past. It tells you little about your future.

Instead, favour logic and simplicity over spurious accuracy.

Swedroe concludes:

Through the step-by-step process described above, it becomes clear that one of the major criticisms of passive portfolio management – that it produces average returns – is wrong.

There was nothing “average” about the returns of any of the portfolios. Certainly the returns were greater than those of the average investor with a similar stock allocation, be it individual or institutional. […]

By playing the winner’s game of accepting market returns, you’ll almost certainly outperform the vast majority of both individual and institutional investors who choose to play the active game.

Simple really is clever when it comes to investing.

It’s also clever when it comes to writing about investing. Must try harder! 😉

Product of the week: Cash ISA rates have fallen due to the Government’s Funding for Lending scheme, says the Telegraph in its pick of the best ISAs. The best one-year fixed rate ISA, paying 2.05%, is from the Nationwide.

Mainstream media money

Note: Some links are to Google search results – these enable you to click through to read the piece without you being a paid subscriber of the site

Book of the week:Monevator reader and self-directed investor John Hulton has written another eBook. The slender tome, D-I-Y Pensions, offers an easy and information-packed overview of the UK pension scene. Best of all, it costs just £2.58 on Kindle, leaving more spare change for your pension.

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Swedroe might have added that you could do much the same with ETFs, possibly at a lower cost (although I do accept that the Vanguard funds can be good value). As for 60% government bonds:… please – you would be luck to keep up with inflation.

2. But nothing about horse meat? It’s surely relevant to diversification: we don’t want to back one horse only in the race…

@Rob (Munro Fund Blog):

1. Great post. Thank you.

2. Final para, 2nd sentence: “So the challenge for intermediaries is how to slice the cake so that they and the clients can adapt to the new world.” Perhaps the real challenge for intermediaries is the rise of the self-directed investor and its corollary, disintermediation.

I also find any portfolio design that has any asset allocation portions under 5% (or even much under 10%) is not worth following when you can cover pretty much all bases with 5 or 6 low cost tracker funds across domestic and international equities and bonds.
As pointed out, the more actively managed funds and trusts you add to your portfolio, the more you will end up creating a higher cost closet tracker fund.
Ditto individual shares when you include dealing costs.

@SemiPassive — To clarify, I personally don’t really mind small allocations if there’s a logical intent (although for most passive investors I fully agree a lot of it can be captured more widely by more global funds, especially with equities). So I don’t have a problem with say “5%” gold or even “4%” UK property or what have you.

The issue for me with “3.17%” as some magical allocation figure. It’s clearly come about because that percentage, back tested, produces the biggest return to date. But such back testing uses a never-to-be-repeated set of circumstances, and implies a spurious and misleading level of confidence about the future. It’s potentially costly, as you rightly say, but also I think it’s potentially misleading.